In a blog entry entitled "Has David Broder Lost His Mind?," Foreign Policy managing editor Blake Hounshell writes that Broder's proposal is "crazy for a number of reasons."

One is that markets don't like tensions, and certainly not the kind that jack up oil prices. Second, World War II brought the United States out of the Great Depression because it was a massive economic stimulus program that mobilized entire sectors of society. Today's American military has all the tools it needs to fight Iran, and there isn't going to be any sort of buildup. Hasn't Broder been reading his own newspaper? The Pentagon is looking to find billions in cuts as it confronts the coming world of budget austerity.

And as I have repeatedly pointed out, "military Keynesianism" - that is, launching wars to stimulate the economy, doesn't work.

Nobel-prize winning economist Joseph Stiglitz has said that war can be very bad for the economy. For example, in 2003, Stiglitz wrote:

War is widely thought to be linked to economic good times. The second world war is often said to have brought the world out of depression, and war has since enhanced its reputation as a spur to economic growth. Some even suggest that capitalism needs wars, that without them, recession would always lurk on the horizon.

Today, we know that this is nonsense. The 1990s boom showed that peace is economically far better than war. The Gulf war of 1991 demonstrated that wars can actually be bad for an economy.

Stiglitz has said that this decade's Iraq war has been very bad for the economy. See this, this and this.

The U.S. is adding trillions to its debt burden to finance its multiple wars in Iraq, Afghanistan, Yemen, etc.

Two top American economists - Carmen Reinhart and Kenneth Rogoff - show that the more indebted a country is, with a government debt/GDP ratio of 0.9, and external debt/GDP of 0.6 being critical thresholds, the more GDP growth drops materially.

The relationship between government debt and real GDP growth is weak for debt/GDP ratios below a threshold of 90 percent of GDP. Above 90 percent, median growth rates fall by one percent, and average growth falls considerably more. We find that the threshold for public debt is similar in advanced and emerging economies...

War always causes recession. Well, if it is a very short war, then it may stimulate the economy in the short-run. But if there is not a quick victory and it drags on, then wars always put the nation waging war into a recession and hurt its economy.

You know about America's unemployment problem. You may have even heard that the U.S. may very well have suffered a permanent destruction of jobs.

But did you know that the defense employment sector is booming?

As I pointed out in August, public sector spending - and mainly defense spending - has accounted for virtually all of the new job creation in the past 10 years:

The U.S. has largely been financing job creation for ten years. Specifically, as the chief economist for BusinessWeek, Michael Mandel, points out, public spending has accounted for virtually all new job creation in the past 10 years:

Private sector job growth was almost non-existent over the past ten years. Take a look at this horrifying chart:

Between May 1999 and May 2009, employment in the private sector sector only rose by 1.1%, by far the lowest 10-year increase in the post-depression period.

It’s impossible to overstate how bad this is. Basically speaking, the private sector job machine has almost completely stalled over the past ten years. Take a look at this chart:

Over the past 10 years, the private sector has generated roughly 1.1 million additional jobs, or about 100K per year. The public sector created about 2.4 million jobs.

But even that gives the private sector too much credit. Remember that the private sector includes health care, social assistance, and education, all areas which receive a lot of government support.

***

Most of the industries which had positive job growth over the past ten years were in the HealthEdGov sector. In fact, financial job growth was nearly nonexistent once we take out the health insurers.

Let me finish with a final chart.

Without a decade of growing government support from rising health and education spending and soaring budget deficits, the labor market would have been flat on its back.

America’s biggest — and only major — jobs program is the U.S. military.

Back to my January essay:

Raw Story argues that the U.S. is building a largely military economy:

The use of the military-industrial complex as a quick, if dubious, way of jump-starting the economy is nothing new, but what is amazing is the divergence between the military economy and the civilian economy, as shown by thisNew York Times chart.

In the past nine years, non-industrial production in the US has declined by some 19 percent. It took about four years for manufacturing to return to levels seen before the 2001 recession -- and all those gains were wiped out in the current recession.

By contrast, military manufacturing is now 123 percent greater than it was in 2000 -- it has more than doubled while the rest of the manufacturing sector has been shrinking...

It's important to note the trajectory -- the military economy is nearly three times as large, proportionally to the rest of the economy, as it was at the beginning of the Bush administration. And it is the only manufacturing sector showing any growth. Extrapolate that trend, and what do you get?

The change in leadership in Washington does not appear to be abating that trend...[121]

So most of the job creation has been by the public sector. But because the job creation has been financed with loans from China and private banks, trillions in unnecessary interest charges have been incurred by the U.S.And this shows military versus non-military durable goods shipments:

Defense spending means that the government is pulling away resources from the uses determined by the market and instead using them to buy weapons and supplies and to pay for soldiers and other military personnel. In standard economic models, defense spending is a direct drain on the economy, reducing efficiency, slowing growth and costing jobs.

A few years ago, the Center for Economic and Policy Research commissioned Global Insight, one of the leading economic modeling firms, to project the impact of a sustained increase in defense spending equal to 1.0 percentage point of GDP. This was roughly equal to the cost of the Iraq War.

Global Insight’s model projected that after 20 years the economy would be about 0.6 percentage points smaller as a result of the additional defense spending. Slower growth would imply a loss of almost 700,000 jobs compared to a situation in which defense spending had not been increased. Construction and manufacturing were especially big job losers in the projections, losing 210,000 and 90,000 jobs, respectively.

The scenario we asked Global Insight [recognized as the most consistently accurate forecasting company in the world] to model turned out to have vastly underestimated the increase in defense spending associated with current policy. In the most recent quarter, defense spending was equal to 5.6 percent of GDP. By comparison, before the September 11th attacks, the Congressional Budget Office projected that defense spending in 2009 would be equal to just 2.4 percent of GDP. Our post-September 11th build-up was equal to 3.2 percentage points of GDP compared to the pre-attack baseline. This means that the Global Insight projections of job loss are far too low...

The projected job loss from this increase in defense spending would be close to 2 million. In other words, the standard economic models that project job loss from efforts to stem global warming also project that the increase in defense spending since 2000 will cost the economy close to 2 million jobs in the long run.

The Political Economy Research Institute at the University of Massachusetts, Amherst has also shown that non-military spending creates more jobs than military spending.

So we're running up our debt - which will eventually decrease economic growth - and creating many fewer jobs than if we spent the money on non-military purposes.

For industry and adequate defense funding to survive ... the two must work together. Otherwise, he added, “this wave of debt” will carry over from year to year, and eventually, the defense budget will be cut just to facilitate the debt.

Secretary of Defense Robert Gates agrees as well. As David Ignatius wrote in the Washington Post in May:

After a decade of war and financial crisis, America has run up debts that pose a national security problem, not just an economic one.

"Eisenhower was wary of seeing his beloved republic turn into a muscle-bound, garrison state -- militarily strong, but economically stagnant and strategically insolvent," Gates said. He warned that America was in a "parlous fiscal condition" and that the "gusher" of military spending that followed Sept. 11, 2001, must be capped. "We can't have a strong military if we have a weak economy," Gates told reporters who covered the Kansas speech.

On Thursday the defense secretary reiterated his pitch that Congress must stop shoveling money at the military, telling Pentagon reporters: "The defense budget process should no longer be characterized by 'business as usual' within this building -- or outside of it."

While morons like David Broder might want to start another war, America's top military leaders and economists say that would be a very bad idea.

Indeed, military strategists have known for 2,500 years that prolonged wars are disastrous.

Mervyn King, the governor of the Bank of England, has tonight made a big intervention into the debate on banking reform. In a speech at Buttonwood, New York, he [listed] much more radical proposals.

1. Forcing the riskiest banks to hold capital "several times the magnitude" of requirements at present.2. The Volcker rule-style enforced breakup of banks into speculative and non-speculative arms.3. The "Kotlikoff proposal", which forces banks to match each pool of risks with a requisite amount of capital, preventing losses in one spilling over into another.4. Stunningly, Mervyn King imagines the "abolition of fractional reserve banking":

"Eliminating fractional reserve banking explicitly recognises that the pretence that risk-free deposits can be supported by risky assets is alchemy. If there is a need for genuinely safe deposits the only way they can be provided, while ensuring costs and benefits are fully aligned, is to insist such deposits do not co-exist with risky assets."

King does not advocate any of these radical plans - but the fact that he goes out of his way to list them, and to place them on the agenda of the UK's Independent Commission on Banking, means that we are not yet at the end of the debate about long-term reform of the banks.

***

Beyond the technicalities, the fact that a central banker in a G7 country is prepared to imagine such outcomes is itself significant.

You suggest that banks should be forced to conform to the underlying purpose of the 1844 Bank Reform Act. You might be aware that I have said publicly that I think ideas in this spirit - such as those advocated by John Kay - certainly merit serious consideration in the debate as to how we reform our financial system. I remain sympathetic to these views. But as I said in my previous letter, I do not want to prejudice the outcome of the Banking commission's deliberations. Now the Commission has been set up, I think we all should wait to see its conclusions."

The 1844 Bank Charter Act ('Reform' is a typo) was a piece of legislation that prohibited commercial banks from printing paper notes (£1, £5, £10 and so on). Before this law was passed, banks were permitted to print as many paper notes as they wanted, up to the point where they printed too many and went bankrupt (as everyone cashed in their paper notes at once).

That situation should sound very similar to the situation that we have today - we currently allow commercial banks to 'print' money in the form of digital bank deposits (the numbers in your bank account). In the years up to 2007, the banks 'printed' far too much of this digital money, to the extent that they - and the economy - started to collapse.

The 'underlying purpose' of the 1844 Bank Charter Act was to prevent the commercial banks creating money and to restore that privilege to the state. It had become obvious to the government of the day that if banks were allowed to create money, they would keep creating money up until the point where it destabilized the economy, so they could not be trusted with this responsibility.

So, in plain English, Mervyn King appears to be saying:

"I agree that banks should probably be stopped from creating money, and recommend John Kay (or Laurence Kotlikoff's) proposals. But it's not for me to say - let's leave it to the Banking Commission."

It's very reassuring to know that the top guy at the Bank of England understands the root of the issue and is promoting solutions that would go a long way to addressing it. Both John Kay and Laurence Kotlikoff's proposals would prevent commercial banks from creating money (or 'issuing credit') for their own benefit at the expense of the wider economy and the public.

Ironically, while King is proposing the potential elimination of fractional reserve banking (i.e. a return to 100% reserves), Ben Bernanke has proposed the elimination of all reserve requirements (i.e. requiring no reserves):

The Federal Reserve believes it is possible that, ultimately, its operating framework will allow the elimination of minimum reserve requirements, which impose costs and distortions on the banking system.

Gulietto Chiesa - Member of European Parliament, 2004 - present (Italy), and Member of the Committee on Legal Affairs. Vice Chairman, Committee on International Trade, and Member of Committee on Security and Defense - sent me the following email:

The team which has done "Zero- inquire on 9-11" is beginning a second step: that of the creation of "Zero-2".: an updating, three years later, with new materials, new steps, a larger vision of the dramatic past ten years of the so called "war against terrorism".

As the previous attempt we are working without big sponsors. That is we need money from common people who want the truth and tools to fight against the war.For this reason we put "Zero-1" on the web not for free, but for euro 2,99If we succeed in collecting money we will go on.

We ask you to help us sending this information to your mailing list, to the blogs you know, to those who may be interested in buying the film and helping us.

You can tell them that there is a site, www.zerofilm.info where you can find the way to buy the film in English, Spanish, Italian, Russian. Very soon also the French language version will be ready.

Saturday, October 30, 2010

Michael Hudson is a highly-regarded economist. He is a Distinguished Research Professor at the University of Missouri, Kansas City, who has advised the U.S., Canadian, Mexican and Latvian governments as well as the United Nations Institute for Training and Research. He is a former Wall Street economist at Chase Manhattan Bank who also helped establish the world’s first sovereign debt fund.

Hudson says that - in every country and throughout history - debt always grows exponentially, while the economy always grows as an S-curve.

Moreover, Hudson says that the ancient Sumerians and Babylonians knew that debts had to be periodically forgiven, because the amount of debts will always surpass the size of the real economy.

Mesopotamian economic thought c. 2000 BC rested on a more realistic mathematical foundation than does today’s orthodoxy. At least the Babylonians appear to have recognized that over time the debt overhead became more and more intrusive as it tended to exceed the ability to pay, culminating in a concentration of property ownership in the hands of creditors.

***

Babylonians recognized that while debts grew exponentially, the rest of the economy (what today is called the “real” economy) grows less rapidly. Today’s economists have not come to terms with this problem with such clarity. Instead of a conceptual view that calls for a strong ruler or state to maintain equity and to restore economic balance when it is disturbed, today’s general equilibrium models reflect the play of supply and demand in debt-free economies that do not tend to polarize or to generate other structural problems.

Every economist who has looked at the mathematics of compound interest has pointed out that in the end, debts cannot be paid. Every rate of interest can be viewed in terms of the time that it takes for a debt to double. At 5%, a debt doubles in 14½ years; at 7 percent, in 10 years; at 10 percent, in 7 years. As early as 2000 BC in Babylonia, scribal accountants were trained to calculate how loans principal doubled in five years at the then-current equivalent of 20% annually (1/60th per month for 60 months). “How long does it take a debt to multiply 64 times?” a student exercise asked. The answer is, 30 years – 6 doubling times.

No economy ever has been able to keep on doubling on a steady basis. Debts grow by purely mathematical principles, but “real” economies taper off in S-curves. This too was known in Babylonia, whose economic models calculated the growth of herds, which normally taper off. A major reason why national economic growth slows in today’s economies is that more and more income must be paid to carry the debt burden that mounts up. By leaving less revenue available for direct investment in capital formation and to fuel rising living standards, interest payments end up plunging economies into recession. For the past century or so, it usually has taken 18 years for the typical real estate cycle to run its course.

Hudson calls for a debt jubilee, and points out that periodic debt jubilees were a normal part of the Sumerian, Babylonian and ancient Jewish cultures. Economist Steve Keen and economic writer Ambrose Evans-Pritchard also call for a debt jubilee.

And as I have previously pointed out, our modern fractional reserve banking system is really a debt-creation system, which is guaranteed to create more and more debts. As then-Chairman of the Federal Reserve (Mariner S. Eccles) told the House Committee on Banking and Currency on September 30, 1941:

That is what our money system is. If there were no debts in our money system, there wouldn’t be any money.

The modern banking system is therefore really a debt-creation system. See this for details.

One thing is for sure. The exponential growth of debt is a structural problem which - unless directly addressed - will swallow all economies which try to ignore it.

Friday, October 29, 2010

Robert Shiller - one of the top housing experts in the United States - says that the mortgage fraud is a lot like the fraud which occurred during the Great Depression. As Fortune notes:

Shiller said the danger of foreclosuregate -- the scandal in which it has come to light that the biggest banks have routinely mishandled homeownership documents, putting the legality of foreclosures and related sales in doubt -- is a replay of the 1930s, when Americans lost faith that institutions such as business and government were dealing fairly.

The former chief accountant of the S.E.C., Lynn Turner, told the New York Times that fraud helped cause the Great Depression:

The amount of gimmickry and outright fraud dwarfs any period since the early 1970's, when major accounting scams like Equity Funding surfaced, and the 1920's, when rampant fraud helped cause the crash of 1929 and led to the creation of the S.E.C.

The original Pecora investigation documented the causes of the economic collapse that led to the Great Depression. It ... established that conflicts of interest and fraud were common among elite finance and government officials.

The Pecora investigations provided the factual basis that produced a consensus that the financial system and political allies were corrupt.

Moreover, the Glass Steagall Act was passed because of the fraudulent use of normal bank deposits for speculative invesments. As the Congressional Research Service notes:

In the Great Depression after 1929, Congress examined the mixing of the “commercial” and “investment” banking industries that occurred in the 1920s. Hearings revealed conflicts of interest and fraud in some banking institutions’ securities activities. A formidable barrier to the mixing of these activities was then set up by the Glass Steagall Act.

Economist James K. Galbraith wrote in the introduction to his father, John Kenneth Galbraith's, definitive study of the Great Depression, The Great Crash, 1929:

The main relevance of The Great Crash, 1929 to the great crisis of 2008 is surely here. In both cases, the government knew what it should do. Both times, it declined to do it. In the summer of 1929 a few stern words from on high, a rise in the discount rate, a tough investigation into the pyramid schemes of the day, and the house of cards on Wall Street would have tumbled before its fall destroyed the whole economy. In 2004, the FBI warned publicly of "an epidemic of mortgage fraud." But the government did nothing, and less than nothing, delivering instead low interest rates, deregulation and clear signals that laws would not be enforced. The signals were not subtle: on one occasion the director of the Office of Thrift Supervision came to a conference with copies of the Federal Register and a chainsaw. There followed every manner of scheme to fleece the unsuspecting ....

This was fraud, perpetrated in the first instance by the government on the population, and by the rich on the poor.

***

The government that permits this to happen is complicit in a vast crime.

As the Great Crash, 1929 documents, there were many fraudulent schemes which occurred in the 1920s and which helped cause the Great Depression. Here's one example of a pyramid scheme in Florida real estate:

An enterprising Bostonian, Mr. Charles Ponzi, developed a subdivision “near Jacksonville.” It was approximately sixty-five miles west of the city. (In other respects Ponzi believed in good, compact neighborhoods ; he sold twenty-three lots to the acre.) In instances where the subdivision was close to town, as in the case of Manhattan Estates, which were “not more than three fourths of a mile from the prosperous and fast-growing city of Nettie,” the city, as was so of Nettie, did not exist. The congestion of traffic into the state became so severe that in the autumn of 1925 the railroads were forced to proclaim an embargo on less essential freight, which included building materials for developing the subdivisions. Values rose wonderfully. Within forty miles of Miami “inside” lots sold at from $8,000 to $20,000; waterfront lots brought from $15,000 to $25,000, and more or less bona fide seashore sites brought $20,000 to $75,000.”

This Mr. Ponzi of course is the man who gave name to the “Ponzi scheme” that many use today. He laid the groundwork for many of the criminals today in the housing industry. Yet during the boom he wasn’t seen as a criminal but a player in the Florida real estate bubble. Here’s a nice picture of the gentleman:

James Galbraith recently said that "at the root of the crisis we find the largest financial swindle in world history", where "counterfeit" mortgages were "laundered" by the banks.

As he has repeatedly noted, the economy will not recover until the perpetrators of the frauds which caused our current economic crisis are held accountable, so that trust can be restored. See this, this and this.

No wonder James Galbraith has said economists should move into the background, and "criminologists to the forefront."

Note 1: I asked Professor Black to comment on this essay, and he said the following:

The amount of fraud that drove the Wall Street bubble and its collapse and caused the Great Depression is contested [keep reading to see what Black means]. The Pecora investigation found widespread manipulation of earnings, conflicts of interest, and insider abuse by the nation's most elite financial leaders. John Kenneth Galbraith's work documented these abuses. Theoclassical economic accounts, however, ignore or excuse these abuses. The Justice Department did not respond effectively to the crimes that helped spark the Great Depression so we have far fewer facts available to us.

The decisive role that "accounting control frauds" played in driving the current crisis is clear. The FBI warned of an "epidemic" of mortgage fraud in 2004 and predicted that it would cause an economic crisis if it were not stopped. The mortgage lending industry's own experts reported that "liar's" loans were "an open invitation to fraudsters" and fully warranted their name -- "liar's" loans -- because fraud was endemic in such loans. Lenders and their agents led these lies. They led the lies for an excellent reason -- the strategy is a "sure thing" (Akerlof & Romer 1993 -- Looting: the Economic Underworld of Bankruptcy for Profit). It guarantees record (albeit fictional) profits, which maximize the CEO's bonuses. The same strategy for maxmizing fictional income maxmizes real losses in the longer term. When many lenders follow the same fraudulent strategy the result is a hyper-inflated bubble followed by a severe crisis.

Control fraud epidemics also produce "echo" epidemics of fraud in other fields. For example, when lenders are control frauds the CEO establishes perverse incentives ("Gresham's dynamics") that corrupt other industries and professions.

By rewarding professionals who are willing to inflate asset values, and refusing to hire honest professionals, control frauds cause the unethical to drive the ethical out of the markets. When one combines deregulation, desupervision, and the perverse incentives of modern executive and professional compensation the result is recurrent, intensifying crises.

Note 2: The Austrian economists point out that it is bubbles which cause crashes. I agree. But as Professor Black points out, fraud is one of the main things which causes bubbles.

Note 3: Of course other factors, such as excess leverage and counterproductive actions by the Federal Reserve, also contributed to the 1930s Depression and the current crisis.

The Founding Fathers not only fought for liberty and justice, they also fought for a sound economy and freedom from the tyranny of big banks:

"[It was] the poverty caused by the bad influence of the English bankers on the Parliament which has caused in the colonies hatred of the English and . . . the Revolutionary War."- Benjamin Franklin

"There are two ways to conquer and enslave a nation. One is by the sword. The other is by debt."- John Adams

“If the American people ever allow the banks to control issuance of their currency, first by inflation and then by deflation, the banks and corporations that grow up around them will deprive the people of all property until their children will wake up homeless on the continent their fathers occupied”.— Thomas Jefferson

"I believe that banking institutions are more dangerous to our liberties than standing armies...The issuing power should be taken from the banks and restored to the Government, to whom it properly belongs."- Thomas Jefferson

“The Founding Fathers of this great land had no difficulty whatsoever understanding the agenda of bankers, and they frequently referred to them and their kind as, quote, ‘friends of paper money. They hated the Bank of England, in particular, and felt that even were we successful in winning our independence from England and King George, we could never truly be a nation of freemen, unless we had an honest money system. ”-Peter Kershaw, author of the 1994 booklet “Economic Solutions”

When he arrived, he was surprised to find rampant unemployment and poverty among the British working classes… Franklin was then asked how the American colonies managed to collect enough money to support their poor houses. He reportedly replied:

“We have no poor houses in the Colonies; and if we had some, there would be nobody to put in them, since there is, in the Colonies, not a single unemployed person, neither beggars nor tramps.”

In 1764, the Bank of England used its influence on Parliament to get a Currency Act passed that made it illegal for any of the colonies to print their own money. The colonists were forced to pay all future taxes to Britain in silver or gold. Anyone lacking in those precious metals had to borrow them at interest from the banks.

Only a year later, Franklin said, the streets of the colonies were filled with unemployed beggars, just as they were in England. The money supply had suddenly been reduced by half, leaving insufficient funds to pay for the goods and services these workers could have provided. He maintained that it was "the poverty caused by the bad influence of the English bankers on the Parliament which has caused in the colonies hatred of the English and . . . the Revolutionary War." This, he said, was the real reason for the Revolution: "the colonies would gladly have borne the little tax on tea and other matters had it not been that England took away from the colonies their money, which created unemployment and dissatisfaction."

Alexander Hamilton, the nation's first treasury secretary, said that paper moneyhad composed three-fourths of the total money supply before the American Revolution. When the colonists could not issue their own currency, the money supply had suddenly shrunk, leaving widespread unemployment, hunger and poverty in its wake. Unlike the Great Depression of the 1930s, people in the 1770s were keenly aware of who was responsible for their distress.

As historian Alexander Del Mar wrote in 1895:

[T]he creation and circulation of bills of credit by revolutionary assemblies...coming as they did upon the heels of the strenuous efforts made by the Crown to suppress paper money in America [were] acts of defiance so contemptuous and insulting to the Crown that forgiveness was thereafter impossible . . . [T]here was but one course for the crown to pursue and that was to suppress and punish these acts of rebellion...Thus the Bills of Credit of this era, which ignorance and prejudice have attempted to belittle into the mere instruments of a reckless financial policy were really the standards of the Revolution. they were more than this: they were the Revolution itself!

And British historian John Twells said the same thing:

The British Parliament took away from America its representative money, forbade any further issue of bills of credit, these bills ceasing to be legal tender, and ordered that all taxes should be paid in coins ... Ruin took place in these once flourishing Colonies . . . discontent became desperation, and reached a point . . . when human nature rises up and asserts itself.

In fact, the Americans ignored the British ban on American currency, and:

"Succeeded in financing a war against a major power, with virtually no 'hard' currency of their own, without taxing the people."

Indeed, the first act of the New Continental Congress was to issue its own paper scrip, popularly called the Continental.

Franklin and Thomas Paine later praised the local currency as a "corner stone" of the Revolution. And Franklin consistently wrote that the American ability to create its own credit led to prosperity, as it allowed the creation of ample credit, with low interest rates to borrowers, and no interest to pay to private or foreign bankers .

Is this just ancient history?

No.

The ability for America and the 50 states to create its own credit has largely been lost to private bankers. The lion's share of new credit creation is done by private banks, so - instead of being able to itself create money without owing interest - the government owes unfathomable trillions in interest to private banks.

America may have won the Revolutionary War, but it has since lost one of the main things it fought for: the freedom to create its own credit instead of having to beg for credit from private banks at a usurious cost.

As economic writer and attorney Ellen Brown has tried to teach to Obama, Schwarzenegger, and anyone else who will listen, the way out of the economic crisis is to stop paying interest to private banks for the creation of credit, and to return to the system of government-issued credit used by the Founding Fathers to create prosperity for the people and to gain independence from their oppressors.

Thursday, October 28, 2010

As I noted earlier today, high frequency traders trade not only stocks, but also futures, options, bonds and currency:

We know that high frequency trading is used to manipulate the stock market. The prevalence of high frequency trading in other markets means that it might be used to manipulate those markets - perhaps virtually all markets - as well.

Indeed, by manipulating futures prices, it is possible to manipulate the current price of the underlying asset.

It could well be that Optiver’s cowboy trading tactics [manipulating the price of oil through high frequency trading] are unique to the company. But as concern grows over the effect that high-octane computerized trading is having on markets worldwide, Optiver’s conduct in the oil futures market raises questions as to whether the relentless competition of this business is forcing companies to engage in similar practices. “These are proprietary trading shops that are masquerading as market makers,” said Tim Quast of Modern IR, a consulting firm that advises corporations on market structure issues.

The Securities and Exchange Commission has opened up an investigation into high-speed-trading practices, in particular the ability of some of the most powerful computers to jump to the head of the trading queue and — in a fraction of a millisecond — capture the evanescent trading spread before the rest of the market does.

Most HFT prop shops choose to keep their identities and intentions secretive, operating under the radar in the hope of improving their chance to profit.

***

The only art more forgivable than economic forecasting is estimating the market size of an industry that will never reveal its true number.

As of last October, Sussman estimated HFT to account for 61% of trades:

TABB Group estimates that high-frequency trading accounts for 61 percent of U.S. equity share volume (remember to double-count average daily shares!) and generates $8 billion per year in trading profits.

The methodology begins with an analysis of institutional equity trading volume that we have been collecting since 2006 from 115 U.S.-based equity head traders, including equity assets under management, average daily volume and the percentage of shares executed in blocks. We extrapolate that data to the broader institutional landscape. Retail trade numbers and data from the government are used to determine retail flow. Data from NYSE and Nasdaq and historical market making volumes enhances our picture of current electronic market-making volumes. Last but not least, we discussed our methodology and trading profit calculations (.0024/share) with several HFT hedge funds, independent high-frequency traders and registered market makers.

Sussman provided the following chart showing that its not just stocks, but that futures, options, bonds and currency are also traded using HFT:

Based on updated volume and trading data shared in the report, TABB Group revises its estimate of US equity trading volume to 70% from 73% as previously announced in July 2009 in a TABB commentary written by Iati, "The Real Story behind Trading Software Espionage," covered by financial and business media around the world.

"Throughout the report you'll find results of an August 2009 poll of 62 market participants on various components of current market structure," adds Sussman, "including flash trading, redefining front running, the tradeoff between order exposure and price improvement and the need for an SEC inquiry into market structure and the ability to achieve good execution.

Recent TABB Group estimates indicate that 70 percent of U.S. equity trading volume, or 61 percent of share volume, is a result of high-frequency trading.

But how does TABB Group arrive at these numbers? Iati explains that there is a large amount of information available in the public domain, including information on assets under management (AUM) at hedge funds and retail order flow. The Westborough, Mass.-based advisory firm combines this publicly available information with proprietary data culled from its institutional research studies, such as average daily volume (ADV). Those numbers are then applied to the broader universe of trading stats. "We have our own sample as a proxy and use our sample of AUM and ADV to help model the broader marketplace," Iati says.

But a September 13 article from CNBC shows that that figure has declined since last year:

Total daily volume in all stocks listed at the New York Stock Exchange went from about 2 billion shares a day five years ago, to an average of about 5 billion shares a day today. High-frequency trading now accounts for about 56 percent of trading volume, according to Tabb Group, but Tabb notes that this figure includes market makers. Five years ago, it was practically nothing.

Though sophisticated, TABB Group's methodology is not an exact science, and the industry's high-frequency-trading numbers are still up for debate. Woodbine's Samelson pegs high-frequency trading at about 40 percent of overall market volume today, with electronic trading accounting for up to 70 percent of total equity volume. According to Samelson, however, it is extremely difficult to put a dollar amount on this volume. Joseph Mecane, EVP and chief administrative officer for U.S. markets at NYSE Euronext, estimates that at least half of the liquidity in the market is generated by high-frequency trading or automated market making.

The bottom line is that unless the government forces reporting by traders, it will be difficult to shine a light into the high frequency trading world bright enough to determine what the exact numbers are.

And Frontline and ProPublica released a new documentary called The Spill which says:

BP has a terrible track record of safety

Workers had "an exception degree of fear" and worried about dying at BP's texas oil refinery, and BP's own plant manager pleaded for safety measures to be implemented. Headquarters said no.

BP's giant Alaska facility was only designed to last until 1987, and then was supposed to be torn down. But instead, according to one of BP's Alaska workers: "They're going to run everything to failure".

BP's philosophy is: "How many lives can we afford to lose before we have to deal with this?"

When Tony Hayward took over as CEO, he said he was going to increase safety ... at the same time he insisted on substantial new cost cutting measures.

Because BP is not being reined in or restricted, and still has a cost-cutting culture, giant, future accidents will occur.

But as Greg Palast notes, The Spill is a whitewash sponsored by Chevron, rehashing information which Palast and others reported on years ago, and falsely implying that other oil companies have stellar safety records.

Other great quotes from today's Congressional Oversight Panel hearing:

Now do you wish to retract your statement that there is no systemic risk in this situation? And the word is "risk" -- not "certainty" -- but "risk"? And I would urge you to do so, because these things can be embarrassing later. [COP Panelist Silvers]

I hope that ... if the Treasury comes back to us and is discussing whether or not we need to deploy further public funds to rescue Bank of America, or such other institutions as might be affected by these events, that we get a similar kind of indifference to their fate after it's too late. Because it strikes me that in light of the mathematics I've gone through with you, it is not a plausible position that there is no systemic risk here. [COP Panelist Silvers]

"So, I mean, it sounds like Treasury as of today has not done even a back-of-the-envelope sketch as to what the potential put-back rights could be to the TARP financial institutions," COP Panelist J. Mark McWatters said, referring to the risk big banks face from investors forcing them to buy back dicey mortgages.

America does not have to continue in a "crisis." We do not have to tolerate abuse of the legal system, systematic errors, bloated fees, and chaos in the housing and financial sector. [Harvard and Iowa law school professor Katherine Porter]

The short answer is "innovation." In her column, "One Mess That Can't Be Papered Over," Gretchen Morgenson of the New York Times reveals the practice in FL and other jurisdictions of destroying the physical note. We really like the 4th from last paragraph, the one about the standard practice of Florida bankers to destroy the original note when an electronic form was created, to "avoid confusion." If you know anything about the checkered history of FL real estate over the past century, this one bites you in the leg.

Is it just possible that creative Florida bankers discovered they could "sell" mortgages many times by conveniently delivering a "copy" of the electronic note for each subsequent sale? By delivering a "good" electronic note to each purchaser, the seller/servicer could kite the Ponzi scheme to the sky -- using the proceeds from each sale to pay interest to each new group of investors. As we told [Washington's Blog] in the failure of First National Bank of Keystone,management hid a Ponzi scheme in the loan servicing area for years, fooling regulators and internal auditors (See 'Audit Risk: Grant Thornton & The Keystone Saga', January 29, 2007).

***

We know people in the servicing sector and related legal specialties who think that the fraud perpetrated upon investors and insurers due to multiple pledges of collateral could be massive. It is also, conveniently enough, another reason for the Obama White House and Fed to continue to prop up the top-three banks with significant GSE exposure -- and the mortgage insurers that help window dress the GSEs already horrible losses.

William K. Black - professor of economics and law, and the senior regulator during the S & L crisis - explained last month before to the Financial Crisis Inquiry Commission why banks gave home loans to people who they knew couldn't repay. The whole piece is a must-read, but here are excerpts from the introduction:

The data demonstrate conclusively that most liar’s loans were fraudulent, which means that there were millions of fraudulent mortgage loans because liar’s loans became common (Credit Suisse estimates that they represented 49% of new originations by 2006). The data also demonstrate that even minimal underwriting of the loan files was sufficient to detect the overwhelming majority of such fraudulent liar’s loans. No honest, rational lender would make large numbers of liar’s loans. The epidemic of mortgage fraud was so large that it hyper-inflated the housing bubble, which allowed refinancing to further extend the life of the bubble (and the depth of the ultimate Great Recession.

***

In the cases where there have been even minimal investigations (New Century, Aurora/Lehman, Citi, WaMu, Countrywide, and IndyMac) senior lender officials were aware that liar’s loans were typically fraudulent. The lenders could not make an honest business out of selling overwhelmingly fraudulent mortgages.

Liar’s loans were done for the usual reason – they optimized (fictional) short-term accounting income by creating a “sure thing” (Akerlof & Romer 1993). A fraudulent lender optimizes short-term fictional accounting income and longer term (real) losses by following a four-part recipe:

Note that this same recipe maximizes fictional profits and real losses. This destroys the lender, but it makes senior officers that control the lender wealthy. This explains Akerlof & Romer’s title – Looting: The Economic Underworld of Bankruptcy for Profit. The failure of the firm is not a failure of the fraud scheme. (Modern bailouts may even recapitalize the looted bank and leave the looters in charge of it.)

The first two “ingredients” are related. Home lending is a mature, reasonably competitive industry. A lender cannot grow extremely rapidly by making good loans. If he tried, he’d have to cut his yield and his competitors would respond. His income would decline. But he can guarantee the ability to grow extremely rapidly by being indifferent to loan quality and charging weaker credit risks, or more naïve borrowers, a premium yield.

In order to become indifferent to loan quality the officers controlling the lender must eviscerate its underwriting.

***

There is no honest reason for a secured lender to seek or permit inflated appraisal values. This is a sure marker of accounting control fraud – a marker that juries easily understand.

In other words, banks made loans to borrowers who they knew couldn't really repay because the heads of the banks could make huge bonuses based on high volumes and fraudulent appraisals, and they didn't care if their own companies later failed.

History demonstrates that if the control frauds get away with their frauds they will strike again.

By allowing the banks to use their political power to gimmick the accounting rules to permit them to hide their massive losses on liar’s loans we have made it far harder to take effective administrative, civil, and criminal sanctions against the elite frauds that caused the Great Recession. Hiding the losses also adopts the dishonest Japanese approach that cripples economic recovery and public integrity.Prosecuting the elites control frauds can be done successfully. Create a new “Top 100” priority list and appoint regulators that will make supporting the Justice Department a top agency priority. That’s how we obtained over 1000 priority felony convictions of elite S&L criminals. No controlling officer of a large, non-prime specialty lender has been convicted of running a control fraud. Only one has even been indicted.

The FBI has written that any discussion of the crisis that ignores the role of mortgage fraud is “irresponsible.”

There are some really bad incentive structures in this industry. Default increases servicing fees, etc. So yes, your example is not outlandish. And the wonder of CDS lets us all bet that the other’s home burns down. Speculative madness, but consistent for a culture that prizes sales about all else.

Whalen also notes that Freddie and Fannie helped to create the epidemic of mortgage fraud, and - like Black - blasts the government for covering it up:

The invidious cowards who inhabit Washington are unwilling to restructure the largest banks and GSEs. The reluctance comes partly from what truths restructuring will reveal. As a result, these same large zombie banks and the U.S. economy will continue to shrink under the weight of bad debt, public and private. Remember that the Dodd-Frank legislation was not so much about financial reform as protecting the housing GSEs.

Because President Barack Obama and the leaders of both political parties are unwilling to address the housing crisis and the wasting effects on the largest banks, there will be no growth and no net job creation in the U.S. for the next several years. And because the Obama White House is content to ignore the crisis facing millions of American homeowners, who are deep underwater and will eventually default on their loans, the efforts by the Fed to reflate the U.S. economy and particularly consumer spending will be futile. As Alan Meltzer noted to Tom Keene on Bloomberg Radio earlier this year: "This is not a monetary problem."

***The policy of the Fed and Treasury with respect to the large banks is state socialism writ large, without even the pretense of a greater public good.

***The fraud and obfuscation now underway in Washinton to protect the TBTF banks and GSEs totals into the trillions of dollars and rises to the level of treason.

***And in the case of the zombie banks, the GSEs and the MIs, the fraud is being actively concealed by Congress, the White House and agencies of the U.S. government led by the Federal Reserve Board. Is this not tyranny?

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